Better Long-Term Investment: Apple Or Alphabet?

Apple Inc AAPL and Alphabet Inc GOOG GOOGL are two of the most well-known companies in the world. They are among the most widely held stocks by actively managed mutual funds, index funds, traders, and retail investors alike. In addition, the two companies combined make up 8.6% of the total S&P 500 index. 

This really hammers home how important the health, growth, and valuations of these companies are for the entire stock market and the millions of investors who hold them. So I thought I’d do a free cash flow analysis of the two to see which is better positioned for the long term. 

Free cash flow is a very important component of analyzing Apple and Alphabet (along with most financial securities) both on an overall and per share basis. Free cash flow is the truest measure of financial value available to shareholders. It is calculated by taking operating cash flow (cash actually generated by business operations) minus capital expenditures (cash consumed to maintain and grow the business).

The ‘free cash’ that is left after all cash consumption can be used to buy back shares, pay dividends, purchase other companies/investments, or left to accumulate on the balance sheet. This is a much purer form of actual value add to shareholders versus ‘GAAP earnings’, ‘EBITDA’, or ‘normalized earnings’ as all those metrics can be massaged, manipulated, and are sensitive to many subjective accounting standards.”

Breaking Down Apple’s Free Cash Flow

This stock has had an epic run over the past two years. Since January 2019 the stock is up 150%. Since March 2020 the stock is up 60%. 

Is the recent run-up justified by improving sales and earnings growth, or is it simply a function of valuation expansion? Over the past five years, the companies’ free cash flow decreased from $70 billion in 2015 to $66.7 billion over the past 12 months. This equates to a total annualized free cash flow decrease of about 0.8% per year. Since the company was repurchasing stock through debt issuance and cash on hand during the period, free cash flow per share has gone up around 4.5% annualized since 2015. 

Apple, with a current enterprise value of $1.5 trillion and free cash flow of $67 billion, is currently trading at a free cash flow to enterprise value of around 22.5. This equates to a free cash flow yield of about 4.4%. Despite a growing percentage of revenue derived from ‘services’ (partly due to plateaued growth on the hardware side), the outlook for future material free cash flow growth seems to be muted over the next several years. 

With a $25 billion net debt position, stagnant cash flows over the past five years, and that pattern likely to continue over the next couple years, plus COVID-19/regulatory concerns, Apple seems fully valued at best and materially overvalued at worst. 

Breaking Down Alphabet’s Free Cash Flow

Alphabet, although a nice performer during the same period, has not compared to the run Apple has had. Since January 2019 Alphabet is up 42.5% and since March 2020 is up roughly 40%.

Over the same five-year period we looked at for Apple, Alphabets’ free cash flow increased from $16.1 billion to $29 billion. This represents total annualized free cash flow growth of around 14% since 2015. The share count was constant through the period so free cash flow growth per share was the same 14%.

Alphabet, with a current enterprise value of $870 billion and free cash flow of $29 billion, currently is trading at a free cash flow to enterprise value of around 30. This equates to a free cash flow yield of about 3.3%. Alphabet is arguably the largest and most powerful owner of data/information on the planet. With a still fast-growing digital advertising market and several other ‘long shot’ initiatives, upper single-digit to mid-double-digit growth can continue for at least the next five years. 

With a significant net cash position of $100 billion, likely continued impressive revenue and earnings growth over at least the next five years, Alphabet seems fairly valued at current prices and with any dip to $1,250 or below representing an attractive entry point despite its own regulatory risks.

Apple looks vulnerable after its recent incredible stock run-up. The law of large numbers also should kick in with the sheer size of the enterprise. With the current market cap $1.5 trillion, if investors are looking for around an 8% return per year over the next five years, that would bring the projected market cap to roughly $2.2 trillion. That $2.2 trillion market cap would equal the total GDP of Brazil. 

In comparing near-flat free cash flow of Apple and growth of Alphabet, the choice is clear. A 10-15% correction in the price of Alphabet would make for an attractive entry price, while caution seems to be warranted for Apple at current levels. 

Eric Mancini, CFA, CFP, CAIA is the director of investment research and a wealth advisor with Traphagen CPAs & Wealth Advisors (www.tfgllc.com). Traphagen is an independent fee-only fiduciary RIA located in northern NJ. He is long Alphabet.